NEW YORK, April 17 (LPC) - Some Business Development Companies (BDCs) have already received board approval to increase the amount of debt that they can borrow after US legislation passed in March allowed them to double leverage on their funds.
BDCs are vehicles that lend to small and mid-sized US companies, and both listed and privately owned BDCs have mixed performance records. The changes are expected to further differentiate performance between managers as adding more leverage, debt and risk could amplify any underperformance.
Apollo Investment Corp (AINV), FS Investment Corp (FSIC), PennantPark Floating Rate Capital Ltd (PFLT), and Gladstone Capital Corp (GLAD) have received board approval to modify asset coverage requirements to allow them to increase leverage.
Ares Capital Corp (ARCC) also said it would discuss specific implementation plans for the provision with its board and other constituents.
A one-year cooling off period is required for funds receiving board approval, but BDCs that seek approval via a shareholder vote at an annual or special meeting will be able to make changes one day after a majority vote.
The passage of the Small Business Credit Availability Act was attached to the US$1.3trn spending bill that was signed into law by President Trump. The legislation effectively increases maximum leverage to 2:1 total debt to equity from 1:1 by lowering asset coverage requirements for BDCs to 150% from 200% previously.
The industry had been working for more than five years to secure this change, which will give the funds more money to lend and allow them to compete more aggressively in the already congested US middle market loan space.
Using additional leverage will allow BDCs to maintain returns while reducing the portfolio risk profile by investing higher in capital structures, and greater funding flexibility will give them access to growth opportunities.
Although BDCs have had leverage capped at a relatively low 1:1, many have invested in riskier junior debt or highly leveraged loans. Fund performance has diverged widely in terms of asset quality, credit risk, portfolio yields and the ability to meet quarterly dividends to shareholders and some BDCs have already been trading at a discount to asset value.
“Relaxed leverage constraints will likely bring forth an ‘Act 2’ of manager differentiation we haven’t seen in recent years even without credit duress as seen in energy, retail, etc. as the impact of underperforming returns should be amplified/underpinned by more risk,” Wells Fargo analysts wrote in their 2Q18 BDC Scorecard.
Standard & Poor’s said the potential for increased leverage in an already competitive environment increases credit risk for the industry and the agency now has a negative outlook on all of its publicly-rated BDCs.
The ratings agency placed its ratings for ARCC, FSIC and Prospect Capital Corp (PSEC) on CreditWatch with negative implications, which prompted PSEC to halt plans to raise additional leverage after initially securing board approval.
PSEC said in an April 6 regulatory filing that it had, “determined to no longer modify, beginning March 25, 2019 (one year from prior board determination), the asset coverage ratio test.”
Fitch Ratings did not take any immediate rating actions on BDCs. Potential negative ratings pressure depends on how individual managers utilize extra leverage with respect to investment strategy and the underlying credit quality of the portfolio as well as the management of funding maturities and liquidity, the agency said.
“Fitch is not taking blanket action following the leverage limit increase, but there could be more differentiation in BDC ratings over time,” said Meghan Neenan, managing director at Fitch Ratings. “Assuming all else equal, if you double leverage unsecured creditors are worse off.”
Ratings for the group of BDCs currently rated by Fitch range between BBB and BB+.
Implementing the new leverage rules will take time and not all BDCs are expected to be able to take advantage of extra leverage. Underperforming BDCs will have less funding flexibility than more diversified platforms with established managers and strong underwriting track records that have consistently outperformed peers.
Funds that do increase leverage are expected not to take it to the limit and will likely maintain a cushion, as previously. Additional leverage is also likely to come via the unsecured debt markets, including bonds, private placements or convertibles, rather than from bank credit facilities.
“Banks are unlikely to want to materially dial up exposure to BDCs. Any increase in leverage these guys get will likely not come from banks, but rather from unsecured debt issuance via the capital markets,” Neenan said. (Reporting by Leela Parker Deo Editing by Tessa Walsh and Michelle Sierra)